What is Going On?
The Fed changed the tone and content of their rhetoric regarding the strength of the economy and the pace and length of their tightening cycle. What caught markets by surprise was Chairman Powell’s exuberance over the strength of the economy and his comments about the duration of the cycle — when he indicated the economy could virtually stay strong indefinitely.1 Further comments by the Fed indicating the neutral rate they’re looking to hike to may not be achieved for a year or more implied higher rates than were expected. If that was not sobering enough, more talking points illuminating that the Fed may hike beyond neutral to slow down the economy was just too much for investors to take.
Bond investors, who previously largely ignored prior rate hikes, were taken by surprise and in a matter of hours paired positions driving the 10-year treasury up by 14 basis points.2 Stock investors also sold equities to reduce risk exposures. On top of the Fed’s tightening program, worries over an elongated trade war with China — whose economy is faltering — heightened investor concerns, driving equity prices around the world sharply lower.
Rising rates are starting to “bite” by negatively impacting interest sensitive sectors in the U.S., like housing, with the 30-year conventional rate exceeding 5%.3 This caught home buyers, economists, and market pundits by surprise. Falling housing prices, slowing new home construction, and weak mortgage originations and refinancing activity started to become worrisome before mortgage rates spiked. At the same time, the vast majority of U.S. companies (80%) providing earnings guidance indicated they will likely miss expectations in the third quarter. Analysts whose estimates have trailed actual reports over this cycle have now adjusted expectations higher just as negative guidance calls them into question. These concerns are the termites that eat at the foundation of the bull trend for the economy and markets. A flattening yield curve conjures recession tremors.
All of a sudden the negative seasonal market bias — that is the month of October — has started to spook retail investors. And as earnings season gets underway, companies cannot continue buybacks, which has been the dominant source of liquidity supporting lofty stock valuations. The markets’ negative price trend could continue over the next few weeks until company buybacks can once again become the big liquidity source for stocks.
We have been counseling investors to start to book profits in the high-flying momentum and growth stocks and to get more defensive with their allocations. In addition, we firmly believe it’s time to reduce market risk by raising cash or hedging. Investors have a bad habit of ignoring rising risks and continuing to chase returns until it’s too late. This can lead to buy high and sell low outcomes that impact capital. We think being disciplined about harvesting gains is the only rational approach to increasing investment success through good and bad market cycles.
However, we think investors need to keep in mind that the few companies that have reported so far have generally beat expectations and the percentage beats are in line with prior quarters — so far. We expect earnings are going to be strong again this quarter and will likely act as a catalyst for a year-end rally with consumer and business sentiment running at or near all time highs. We will see if the combination of a strong economy, strong corporate results, and strong sentiment are enough to entice investors back into stocks as record company buybacks take hold at the beginning of November. Until then it may be a little spooky. Trick or treat? Your guess is as good as mine.
1 Ivanovitch, Dr. Michael. “US Inflation Is the World's Most Important Economic Variable.” CNBC, 8 Oct. 2018
2 Bloomberg. 3 Oct. 2018
3 Kearns, Deborah. “Benchmark National Mortgage Rate Tops 5 Percent.” Bankrate, 11 Oct. 2018
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